Wednesday, December 12, 2007

Fed, ECB, Central Banks Work to Ease Credit Crunch (Update11)

By Scott Lanman

Dec. 12 (Bloomberg) -- The Federal Reserve, European Central Bank and three other central banks moved in concert to alleviate a credit squeeze threatening global growth, in the biggest act of international economic cooperation since the Sept. 11 terrorist attacks.

The Fed said in a statement it will make up to $24 billion available to the ECB and Swiss National Bank to increase the supply of dollars in Europe. The Fed also plans four auctions, including two this month that will add as much as $40 billion, to increase cash in the U.S.

Central bankers took the action after interest-rate reductions in the U.S., U.K. and Canada failed to allay concerns that banks will reduce lending, which may send the U.S. into recession and hobble growth abroad. Borrowing costs have climbed as mounting losses on securities linked to subprime mortgages caused lenders to conserve cash.

``This is shock and awe,'' said Fred Goodwin, a fixed- income strategist at Lehman Brothers Holdings Inc. in London. ``The fact that it's coordinated means they have joined together in the war to attack the problem, which is that banks don't trust each other.''

A Fed official told reporters that the U.S. central bank's efforts won't add net liquidity to the banking system. The plans are aimed at buttressing so-called term funding markets, such as for one-month loans, rather than overnight cash. The Fed will balance its various operations, including daily repurchases of Treasury notes and direct loans to banks.

Bank of England

The Bank of England increased the size of reserves it will auction in money market operations and widened the range of collateral it will accept on three-month loans.

After rallying earlier today, stocks surrendered much of their gains. The Standard & Poor's 500 Index rose 0.6 percent to 1,486.59, retreating from an increase of as much as 2.3 percent. The S&P 500 tumbled 2.5 percent yesterday as investors expressed disappointment at the Fed's quarter-point reduction in its benchmark rate. Treasury notes fell and the dollar strengthened against the yen.

``Ultimately the problems we're facing go beyond illiquidity,'' said Larry Hatheway, chief economist at UBS AG in London and a former researcher at the Fed ``It's another step in the healing process, but we have some way to go.''

The Fed official said on condition of anonymity that today's announcement wasn't a reaction to the slump in stocks yesterday. The agreement was reached with central banks abroad last week and was announced today at a time when markets were open in Europe and the U.S., he said.

`Elevated Pressures'

The measures are ``designed to address elevated pressures in short-term funding markets,'' the Fed said in a statement in Washington. The U.S. central bank said it's considering setting up a permanent arrangement to provide funds to banks through so- called term auction facility operations.

``The interbank market isn't working very well, and when the interbank market doesn't work very well globally, this creates some problems,'' Bank of Canada Governor David Dodge said in an interview today. ``It's part of our normal role as central banks to try to, if you will, unblock that.''

Fed Vice Chairman Donald Kohn and other officials have expressed frustration that banks haven't made more use of direct loans from the U.S. central bank. Policy makers reduced the so- called discount rate to half a percentage point more than the benchmark rate in an effort to stimulate use of the resource.

Banks' Struggle

The world's major central banks have been struggling to restore liquidity since the market for assets backed by U.S. subprime mortgages collapsed because of rising foreclosures. In August, the Fed was forced to cut its discount rate and join the European Central Bank and Bank of Japan in pumping billions of dollars into the banking system.

``They had to do something,'' said Goodwin at Lehman. ``Now that this has happened we can spend less time adding up the numbers and instead think of this as a sentiment-changing moment, when central banks tackled the problem aggressively.''

The Fed has lowered its benchmark rate three times, and was joined last week by the Bank of England and Bank of Canada. The ECB has shelved planned rate increases. On Wall Street, the chief executive officers of Merrill Lynch & Co. and Citigroup Inc. lost their jobs. Confidence among U.S. consumers, whose spending accounts for more than half of gross domestic product, has weakened.

``The central banks have been behind the curve on the coordination front,'' said Marco Annunziata, chief economist at Unicredit MIB in London. ``It's striking that only now we get a coordinated response to what has been a common problem.''

Auction Schedule

The first U.S. auction, of 28-day funds, will be $20 billion on Dec. 17. The second, on Dec. 20, will provide up to $20 billion. The central bank plans two more auctions, Jan. 14 and Jan. 28, with possible additional operations thereafter, the Fed said. Officials will consider the results and effects of the auctions as they determine whether to proceed with more and how long to set the maturities.

The Fed official said the central bank won't reveal the names of those bidding for the funds. The auctions aren't aimed at helping particular banks, he added. Officials don't expect there will be any ``stigma'' attached to lenders bidding for the funds, the official said.

``By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity,'' the Fed statement said.

Difference From Repos

The Fed's New York branch conducts repos most days to steer the federal funds rate, the overnight lending rate between banks, to the target set by policy makers. Only primary dealers, authorized to trade directly with the New York Fed, participate.

By contrast, all ``generally sound'' deposit-taking institutions can participate in the term auction facility, the Fed said. The Fed's 12 district banks will accept the same ``wide variety'' of collateral that is used for discount-rate loans, the statement said. The regional banks determine the haircuts on the assets submitted.

The Federal Open Market Committee also authorized ``temporary reciprocal currency arrangements,'' or swap lines, for up to six months, with the ECB of as much as $20 billion and $4 billion to the SNB ``for use in their jurisdictions.''

Six years ago, the Fed sold $50 billion to the ECB after the destruction of the World Trade Center restricted foreign banks' access to dollars.

Yesterday, U.S. stocks had their biggest drop in a month and two-year Treasury yields plummeted after the Federal Open Market Committee lowered the benchmark rate by a quarter-point to 4.25 percent and said cumulative cuts of 1 percentage point this year should promote ``moderate growth.''

Some investors expected a larger reduction of a half-point to stave off a recession. The Fed's board also reduced the discount rate, covering direct loans to banks, by a quarter point to 4.75 percent, half of what many economists predicted.